My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.
When Sir Mervyn (soon to be Lord) King took over as Bank of England governor 10 years ago, inflation was below target, the economy was more than a decade into a prolonged upturn and the banking crisis was not even a twinkle in anybody’s eye.
Today, as he hands over to Mark Carney, things are rather different. On July 1 2003, the latest published reading for consumer price inflation was 1.3% and, while the official target at the time was specified differently, inflation had not been above the current 2% benchmark in over six years.
Now, inflation is 2.7% and has not been at or below the 2% target since autumn 2009. Indeed, for 81 of the past 96 months it has been above target.
2003, with hindsight, was a year of very strong growth for the economy, 3.8%, though the Bank’s monetary policy committee still felt concerned enough to vote for a reduction in interest rates to the then daringly low level of 3.5% at King’s first meeting as governor in July 2003.
Now, while forecasts for growth this year are creeping higher, the consensus is only for 0.9% this year, even though Bank rate has been at the record low level of 0.5% for more than four years.
Worries about the banking system did not trouble King in his first four years or so. Up to the outbreak of the crisis in the summer of 2007, his publicly expressed view was that British banks were sound, and perfectly capable of weathering storms arising from bad US subprime loans.
Now, the banking system is still being repaired, with banks required by the new Prudential Regulation Authority (part of the Bank) to raise another £27bn of capital. The outgoing governor insisted in his final Mansion House speech on Wednesday that this will enhance their ability to lend.
The banks see it differently and, while mortgage lending is picking up - in May gross lending was at its strongest since the autumn of 2008 - business lending and overall credit growth remains very weak.
I am not suggesting these changes can all be laid at King’s door, or that he is handing over a poisoned chalice to his successor. The picture looks better than a year ago and, indeed, considerably better than the 2-3 years before that. When he took over in 2003 he was in some respects inheriting from himself, having been deputy governor and before that chief economist.
Even so, Carney faces some serious challenges and he has given himself only half the time; five years compared with the 10 years in office that has been the norm for recent governors. He is a man in a hurry.
The first challenge is the issue of the moment, quantitative easing (QE), or central bank asset purchases. Ben Bernanke, the Federal Reserve chairman, has ably demonstrated the markets’ addiction to QE by indicating when the Fed will reduce, or taper, its current $85bn (£54bn) of monthly asset purchases. He suggests the tapering will begin later this year and that QE will stop altogether by the middle of next year.
The turmoil this timeline has generated could, if it impacts adversely on economic activity, force the Fed into keeping QE going. In the meantime, however, it creates a dilemma for the new governor.
Though growth has a long way to go before it is anything like normal (and normal now is nothing like what the economy achieved in 2003), it has been picking up. Retail sales jumped 2.1% in May and purchasing managers’ surveys and other evidence point to stronger growth in the second quarter than the 0.3% rise in gross domestic product in the first. Official figures this week may nudge up some of Britain’s growth history.
Signs of stronger growth can be taken together with the fact that inflation rose from 2.4% to 2.7% last month, and seems certain to go higher when this month’s figures are released in July (the new governor would be forced into a letter to the chancellor if it goes to 3.1% or more). This should be enough to kill talk of an early resumption of the Bank’s £375bn QE programme.
When you add the fact that the Fed is starting to think about its exit strategy, it would be odd for the Bank to contemplate doing the opposite. The only argument for doing so, the rise in gilt yields (the interest rate on UK government bonds) that has resulted from the Fed’s exit talk, is surely no reason at all. It would be a bizarre world if one central bank felt obliged to ease policy in response to another’s attempt to begin the process of tightening.
Carney’s task, surely, should be to work with other central banks to find a painless way - if there is one - of weaning the markets off this extraordinary support.
His second challenge is to come up with policy that makes a difference. Here, the buzz-phrase is explicit forward guidance. A Carney-led MPC might say Bank rate will stay at 0.5% until the unemployment rate has fallen below, say, 6.5% from 7.8% now - similar to earlier Bernanke guidance on QE. Or it might say that there will be no change in rates until GDP - in either real or money terms - has reached a certain level. The new governor is known to favour this kind of forward guidance.
It is not, however, as straightforward as it sounds. Unlike the Bank of Canada, where the governor makes the final decisions on monetary policy, the nine-member, one person-one vote MPC is democratic. Carney no doubt knew this when he took the job, but that was before King was outvoted in each of his last five meetings. The culture shock could be considerable.
Even if he can get the rest of the MPC to agree on forward guidance, it may not be particularly effective, as Russell Jones, an economist with Llewellyn Consulting, points out. If the markets sense the Bank will not necessarily stick to its pledges, perhaps because future MPC members will not feel obliged to abide by them, they will see through them. “If a central bank lacks credibility, it is effectively powerless,” he says.
The third challenge is the biggest of all. Britain, for a time at least, was an economy that could grow by 3% a year alongside sub-2% inflation. Now it is a sub-2% growth economy alongside 3% inflation. The trade-off has worsened significantly.
The longer inflation persists at near-3% rates, the more firms, households and markets will believe the 2% target is a fiction. Carney’s biggest task in his five years will be to return to Britain to lower inflation and higher growth. It is not clear whether he as the tools, or the scope, to do so.